This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

December 19, 2013

Best 5 Stock Investments for 2014

If now is truly the season for activist investing, then these stocks’ owner-operator champions are set to unlock shareholder value

The Internet is currently flooded with a tsunami of stock market predictions—from brokerage firms, investment strategists, financial media types and every flavor of portfolio manager. Many of them even sport sort of impressive scorecard.

We at ThinkAdvisor accept the common industry disclosure that “past performance is not indicative of future results,” and its corollary that foresight is not 20-20.

So to take part in this annual ritual, we sought someone with direct oversight responsibility for managing unrelated investors’ wealth (sorry investment strategists); a fund with a record of success going back at least 10 years (and this has been a challenging decade); and a fund that has had market-beating current performance even by today’s buoyant standards.

That led us to the Kinetics Small Cap Opportunities Fund (KSCOX) and its research affiliate Horizon Asset Management. In a year in which the small-cap Russell 2000 index has returned (so far) a whopping 32%, KSCOX has vastly outperformed with year-to-date returns of 56%.

And over a choppy decade in which the Russell 2000 has delivered 105%, KSCOX has bested its benchmark with returns of 136%.

Admirably, the fund exhibits an unusual degree of conviction and concentration, with a turnover ratio of just 11% and its top portfolio holdings amounting to more than half the fund’s assets, based on Q3 data from Kinetics’ website, which also lists both no-load and Class A and C shares.

So is there a method to KSCOX fund shareholder gladness? “We buy and sit and wait,” co-portfolio manager Matthew Houk told ThinkAdvisor in a phone interview from his office in New York.

That’s the simple explanation. The more technical description Houk offers is that the “equity yield curve” is the cornerstone of Kinetics’ management philosophy—“a fancy sounding term for identifying investment opportunities with abnormally high discount rates.”

In other words, Houk says he and co-manager Peter Doyle are relatively less interested than other portfolio managers in a company’s recent quarterly performance as long as they see catalysts to high future performance.

Apart from a different emphasis in portfolio selection, Houk says his fund also differs in its process:

“When it comes to identifying investment opportunities, we focus on what we call predictive attributes” rather than “descriptive attributes.”

The latter looks for stocks in a certain sector or market cap, whereas the former approach finds that three attributes tend to predict performance: owner-operators—where the “day-to-day decision maker is a large shareholder;” spinoffs, where a corporation unlocks value by segregating some of its assets into a separate entity; and dormant assets, where a corporation extracts value from non-performing assets.

With those principles, here are five stocks Houk expects to outperform in 2014.

Carl Icahn owns 90% of the holding company bearing his name, making it a quintessential owner-operator scenario, Houk says.

The famed corporate raider is known for building up large stakes in the companies he buys then pushing to unlock value through his shareholder activism.

Icahn gave his most recent demonstration of that technique late last month when he filed a shareholder proposal with Apple asking the firm to use its cash to buy back shares to increase their value. That proposal should be a topic of great investor interest come Feb. 26, when Apple holds its annual shareholder meeting.

In his company’s earnings statement last month, Icahn said “there has never been a better time than today for activist investing, if practiced properly,” referring to mediocre management and the ease of buying in a low-rate environment, Bloomberg BusinessWeek reported.

Investors, not just diners, have been feasting on the national restaurant chain this year, pushing up its stock 52% year-to-date. But what Houk finds most appetizing is the role of its non-executive chairman of the board, Nelson Peltz, a hedge fund billionaire whose Trian Fund owns a 21% stake in the stock, in addition to Peltz’s personal 4% ownership.

That owner-operator attribute is predictive of further gains in shareholder value as far as KSCOX is concerned; and indeed Wendy’s is the fund’s second largest holding, at 7.1% of the portfolio, second to and close to its 7.3% stake in Icahn Enterprises.

Houk sees a bright future for the stock:

“When you look at Wendy’s, it has essentially no non-U.S. exposure,” he says. “That signals opportunity to grow over the long-term.”

Real estate developer The Howard Hughes Corp. is a three-fer in the constellation of “predictive attributes” that Kinetics looks for in selecting stocks.

Like Icahn and Wendy’s, it’s got an owner-operator in hedge fund hero Bill Ackman, whose Pershing Square Capital Management, follows the activist model of buying large stakes in a company in order to push management for changes that would boost shareholder value. Pershing’s stake in HHC is just under 5% and Ackman serves as its independent chairman of the board.

HHC was also a spin-off, unlocking hidden value that was lost in the larger real estate firm General Growth Properties.

Its third predictive attribute, dormant assets, lay in its market emphasis on master-planned communities in places like the Summerlin suburb of Las Vegas, which has benefited hugely from the recovery in residential real estate.

Jarden owns Mr. Coffee, Crock-Pot and a large number of other household consumer brands; it recently bought and plans to develop Yankee Candle, a trendy scented candles store with an attractive retail presence.

Houk calls Jarden “fairly significantly undervalued,” saying, “the company could pay down its net debt in approximately three years” if it wanted to.

If you like Icahn Enterprises, then you’ll probably also like auto parts maker Federal-Mogul, which is about 80% owned by Icahn, who serves as the firm’s independent chairman of the board.

Icahn championed the maker of powertrains and car safety solutions after it was left for dead when the financial crisis crushed the U.S. auto industry. The company sold off again this year when investors grew nervous about a low cash balance and worried about covenant breaches and potential insolvency.

Icahn, who owned about 50% of the company at the time, recapitalized FDML through a rights offering, took his own stake up to 80% and agreed to backstop the company in case it needed financing in the future. The shares have rocketed ever since, rising 151% year-to-date.

FDML and the other owner-operator companies favored by KSCOX “tend to trade at large discounts for abnormally large amounts of time,” Houk says.

That is in part because so much of investment flow these days passes through index funds and ETFs, which he says bypass companies that have only a limited free-float, which is typically the case in owner-operated companies.